Sunday, September 20, 2009

You Really Shouldn't Care So Much About Flash Trading

disclaimer: do not waste your time getting sidetracked into OTHER aspects of high frequency trading - this post is about one thing: FLASH TRADING. do not leave me comments about how much you hate high frequency trading - focus on the simple facts of flash trading, and I will be happy to engage in a dialogue with you.

First, let's step back and remind ourselves what flash trading is: when you enter an order on certain exchanges, you have the option to elect to have that order "flashed" to members of that market center to give them the opportunity to match prices that may be available on other exchanges. You, as the order executor, elect to have your order flashed because if the order is executed internally, you don't have to pay an additional charge to route your order out to another exchange. It's that simple. Let's make it a little more concrete: GE is trading $16.50 - $16.51, but you execute your orders on DirectEdge, and the best offer is currently on ISLD. When you enter a flash order in DirectEdge to buy 100 GE @ 16.51, all it does is give potential sellers in DirectEdge the opportunity to sell it to you at $16.51 before DirectEdge routes your order out to the other exchange. There is no theft, there is no front running, there is nothing to rant and rave about.

Now, I have all the respect in the world for Barry Ritholtz. I think he's a tremendous blogger who gets to the truth behind the data, and behind many biased mainstream media reports. Generally, he knows what he's talking about. So it was with dismay that I returned from a weekend out of town, sat down to catch up on some of his recent posts, and found this diatribe against flash trading. Ritholtz's piece arose because the SEC has proposed a ban on flash trading. Next they'll debate it, discuss it, hear comments on it, and vote on it.

A few months ago I wrote my most-read post ever, titled "We Fear What We Don't Understand." Let's revisit the flash trading component of that piece:

"Now, the intent of flash orders is to allow participants in a given market center the opportunity to improve the current bid or offer so that an order doesn't need to be routed away to another market center.

An example: let's say GE is trading $11.45-$11.50 at DirectEdge, but that there is an $11.46 bid on ISLD (an ECN). If you submit an order to sell stock at $11.46 on DirectEdge, they flash this order to select market participants to offer them the opportunity to fill your order - otherwise the order gets routed out to ISLD and you (the seller) have to pay an extra fraction of a penny for the routing. As I tried to explain on some other posts regarding flash trading, this is basically a hyper-speed modernized version of how the NYSE specialists used to verbally quote orders to offer people in the crowd the opportunity for price improvement: "if GE was 11.25-11.27 50k up, and you walked in to sell 50,000 shares, the specialist would say out loud “25c bid 50,000, 50,000 at 26c, SOLD.” Anyone could say "TAKE or BUY'EM" before the specialist said "SOLD" which would result in the seller getting price improvement to $11.26 and if no one interrupted him, the trade was done at $11.25. Markets have NEVER been setup such that every participant has the same opportunity to trade on every quote."

There was also an op-ed in the WSJ a few weeks ago defending and explaining flash trading. The op-ed is accurate, well written, and clear, yet Ritholtz still managed to take offense to it:

"The WSJ had an Op-Ed last month, In Defense of ‘Flash’ Trading, that suggested that “Flash trading is like offering to sell your house to your neighbor before you officially put it into the real estate listings.”

That description is, of course, utterly false. We have alternative exchanges where you can offer stocks privately to other willing buyers (i.e., Instinet). Flash trading is more like having access to private info from the sellers, knowing what they will accept, stepping in front of legitimate buyers, and then flipping the house to those buyers while capturing 0.001% of the transaction. No benefit to the seller, to the neighborhood or to anyone else — all at a small cost to the buyer."

I can't fathom how someone as intelligent as Ritholtz could screw this concept up: when you "step in front of legitimate buyers" it means you are paying more than anyone else. Thus, it's not possible to pay the highest price and then flip it back to the buyers who are willing to pay LESS and make a profit. If you buy stock against a flash order, and offer it out again, you're taking risk - you're not stealing fractions of a penny from anyone or arbitraging anything - what you ARE doing is helping the person who flashed the order in the first place by offering them price improvement and eliminating routing costs.

Now, there is certainly the POSSIBILITY that instead of John Q FlashMan seeing the flash order - let's say it's an order to buy GE - and instead of offering to sell stock to the flash order, he decides to act illicitly and buy stock in GE as fast as he can, before the original GE order gets completed. This is called front running - it's blatantly illegal, and you'd be hard pressed to find anyone who would argue that it's defensible. However, if the traders entering flash orders constantly find themselves being frontrun, well, guess what - they'll stop entering flash orders. They are not idiots. Guys using flash orders are highly cost sensitive, (that's the very reason they use flash orders in the first place!) and notice when their execution costs (both explicit: commission/fees, and implicit: impact costs, or negative costs associated from other trading ahead of their orders) increase - if flash orders are hurting them, they won't flash them.

Flash trading is a non-issue that people like Chuck Schumer and Ted Kaufman have jumped on in an effort to make it look like they are fighting for the little guy's rights on Wall Street. The reality is that a ban on flash trading will have little to no effect on any sort of market dynamic, and will not help the little guy at all, but will increase trading costs for some traders.

-Kid Dynamite


Anonymous said...

Thank goodness there is at least one blogger who is willing to try to make the effort to understand what "flash trading" is... having read a lot of otherwise intelligent bloggers' commentary, I have had to scratch my head and wonder if they've completely forgotten what frontrunning means.

You get bonus points for understanding that there are various exchanges and considering actual scenarios for how order routing might work in the real world (other than "OMG we send our orders to NYSE, where Goldman flashes our orders and makes a quarter of a penny, the bastards!")

Anonymous said...


I appreciate your level-headed view on this and related topics. I've exchanged some posts with you on zero hedge, but haven't posted there in a while as the mindless cheerleading has become overwhelming. Its comments like the ones you have been getting on Clusterstock and ZH today that deter me from even bothering to try and inject some logic into what I'll generally call the electronic trading debate (flash, hft, dark pools, algorithmic trading, etc...). Its like trying to argue abortion with the pope.

Anonymous said...

the problem i see with your reasoning is this: NMS was intended to level the field amongst market venues. The rules attempt to ensure that the best bid and best offer on ANY venue (be it Arca or Nasdaq or DirectEdge) is protected from being 'traded through.' In your GE example, the best offer on ISLD does not get filled because of the flash order. If the GE seller wants to sell at 16.51 let him offer 'out loud' at .51 and he will get filled. Using a flash quote in this case dis-advantages the ISLD offer at .51 which should have been filled. The whole concept behind NMS is to 'level the playing field,' flash orders create an advantage for the members of a specific market center.

Kid Dynamite said...

that is absolutely correct, Anon... yet their offer still was not traded through. I completely understand your point - but that's a drawback with market fragmentation.

Richard said...

Kid, I put this comment on Clusterstock but I'm also putting it here in case you're not checking that post anymore.

I agree that flash order are inoffensive if they are used by principals, but I disagree if they are used by agents. If a prop trader is willing to accept having his order broadcast in exchange for reduced routing fees, fine. But what happens when a broker working an agency order uses flash orders? The broker gets reduced routing fees, allowing him either to offer lower explicit comms to his client and win more business or else pocket the difference. It's the client who pays for any potential "front-running" in poorer execution. I use "front-running" in quotes because my understanding is that it is not illegal for a third party who sees flash orders to trade on that information.

In the example from your post, if GE is 16.50-51 on NBBO but 52 offered on Direct Edge, a broker working a buy order can flash a buy at 51. A third party's machine monitoring these orders on Direct Edge has 30ms (ok, a little less) to go out into the market and buy at 51, knowing that there's will shortly be another bidder at 51. Do you concur that this can happen legally, or do you assert that this would be illegal?

Over time, a broker who uses flash orders for customer orders will show worst execution. However, most customers focus on the explicit commission costs, some look at the cost relative to market (unfortunately, the "front-running" cost won't show up here since market/VWAP also moves) and only a few really look at the total costs including market impact.

Kid Dynamite said...

yes Richard - the scenario you laid out is possible. I actually don't know if it's blatantly illegal - probably not, but if it is happening, then it's exactly why people want to blan flash orders, and justifiably so. It's definitely not the intended use of flash orders.

However, the moral of the story is - 1) if this is happening to you, find a new broker! 2) if you are getting taken advantage of on your flash orders, do NOT FLASH THEM!

Richard said...


I have a particular bugbear with agents who do not act in the best interests of the principals. Sadly, after nearly two decades in the finance business, I'm pretty convinced that's most of them.

I'd love to know what fraction of DirectEdge's flash orders are sent by principals and what fraction by agents. If it's all by principals, then I have nothing more to say. If it's mostly by agents....

The thing is, I can't see any reason why a party with the technical capabilities - who are getting rather numerous - wouldn't take advantage of the information granted by the flash orders. And this WILL cause worse execution for the beneficial users. Whether or not the worse execution outweights the fee savings is unclear.

What if the SEC mandates that all beneficial users of direct orders sign a statement acknowledging that the scenario I described is both possible and legal, and that they still wish to use them? Sort of a health disclaimer, like "Smoking while pregnant can cause birth defects in babies".

Kid Dynamite said...

Richard - i see you point - the bottom line is that everyone also has a responsibility for their own orders right? that was one of the first points: IF flash orders are being taken advantage of them, THEN don't send flash orders. it's not rocket science. and "i'm not sending them, my broker is sending them on my behalf" is no excuse - find a broker who isn't sending them!

it's just like if you want to buy a billion shares of IBM, your broker doesn't go out and show a bid for a billion shares - if he does, everyone in the market owns him and trades in front of him. If your broker does that, you find a new broker.

one reason that the flash receivers might not use the info unethically/illegally (And yes - i absolutely think it should be illegal to take the information from a flash order and trade ahead of the order) would be that that would end the flash orders, and the flash receivers find the flash orders beneficial.

it's an unarguable fact that there are certain people - mostly smaller professional day traders, who want the ability to send flash orders because it saves them money. they should be allowed to.

Kid Dynamite said...

i guess my point, richard, is that there are lots of things in the market that can hurt people if they are not used properly (leveraged ETF's, MARKET ORDERS!), but that doesn't mean we should ban them.

i think the number of investors who are hurt (on price gaps) by using market orders probably DWARFS the number of investors who are hurt by using flash trading - yet no one is suggesting we ban market orders.

Richard said...


Unfortunately, my guess based on what I know about traders and also on the recent financial market crisis is that you're being a bit optimistic if you think collective self-interest will overcome individual self-interest in finance. Think tragedy of the commons. Then again, Akerlof's rather elegant proof of the impossibility of the used car market ran up against the existence of enough stupid/complacent/otherwise non-profit maximizing sellers.

At any rate, I work in high frequency trading. I focus on non-US markets, so flash orders are not an issue for me personally. But I can tell you that the argument that taking advantage of these orders would eventually result in their elimination would only spur us on to take advantage of them sooner; get while the getting is good. Our rationale would be that, if it was legal, someone else would take this advantage if we didn't. Also, we're quite used to the concept that a trade will eventually decay and become overbroked, and we'll have to move on to a new trade.

I happen to agree with you that finance is governed by caveat emptor. And I also believe that is the way it should be. So I'm against banning flash orders. However, I am very much in favor of educating users about the pros and cons, and asking them to make an explicit decision. And I do believe the cons are likely to outweigh the pros for many, if not most, investors. But I'm happy for them to make up their own minds, as long as they're aware of the issues.

Richard said...


Btw, it can be remarkably difficult to find out if a broker is using flash orders. One part of my company, not involved in high frequency, uses brokers in the US (top 3 in US market share). When the orders became news, they tried to find out if the brokers were using them. The sales contacts didn't know. Their first line trading support didn't know. After a couple of days, their trading developers (rather grudgingly) admitted that, yes, they were using them on our orders. When asked why, they responded that we'd never instructed them not to. This was on trading lines set up several years earlier, before flash orders existed. And they'd not seen fit to update us when they started using the orders. We're now using a broker whom we're hoping gives better disclosure.

Kid Dynamite said...

Richard - points taken. One thing I have trouble explaining to people is that there wasn't really ever any incentive for me to act illegally when i was trading - it's the textbook example of killing the golden goose.

I make the same argument for why it didn't make sense for us to just get long a billion dollars on day one and hope the market went up and we'd get rich: it wasn't worth it, even though it's not "my money" at risk. The price of being wrong was losing that golden ticket. In other words - you don't have to cheat and steal to make money on wall street. You don't have to bet the house's money in such a way that will bring down your bank if you're wrong. It just doesn't work like that - even though there are always bad apples

Daniel said...

Good point re market orders. I haven't used a market order in years.